Romer writes that macro-economists casually dismiss facts, and the profession as a whole has gone backwards over the past few decades, losing precious and hard-won knowledge. He does not consider WHY this happened. What are the methodological flaws that create the possibility of moving backwards, losing knowledge, affirming theories known to be in conflict with facts. How is it that leading economists can confidently assert theories which border on lunacy, and receive Nobel Prizes instead of psychiatric treatment?

This is due to the famous AS-IF methodology of Friedman, which gave economists a license for lunacy. Friedman came up with this defense of orthodoxy when numerous emprical investigation revealed clearly that firms did not maximize profits, did not know their marginal costs, typically used mark-up pricing, and did other things which did not square with neo-classical theories. Friedman’s argument has been universally condemned by logicians and philosophers as an instance of the logical fallacy of “Affirming the consequent” – the use of modus ponens in reverse. That is, Friedman says, in effect, that theory T implies observable consequence C. We observe C, and therefore we can affirm that T holds. This is obviously fallacious since many different theories, inconsistent with T, may also imply consequence C. Even more importantly, a false theory T will always imply consequences C* which are not observed — since the theory is false, it will have consequences which are false. Ignoring all of these problems, Boland uses an instrumentalist interpretation to defend Friedman, just like all economics textbooks. He writes that even though critics universally condemn his logic, Friedman is right, and ALL the critics are wrong.

In my lecture on AM2L07 (code for Advanced Micro II: Lecture 7) Methodological Mistakes: Prospect Theory and Psychology Protocols, I explain why Friedman is wrong and his critics are right by discussing this methodological debate within the concrete context of trying to understand search theory. Consider a hypothetical problem where a person is searching for the highest wage. He goes from one firm to next. At each point he is offered a job at a certain wage W. He can accept and quit searching, or reject the offer and go on searching. We want to find a theory which explains search behavior that we observe in lab experiments designed to emulate this situation.

In simple models, it is easy to show that optimal search sets a reservation wage W* and the laborer searches until he/she finds the first offer above this value. The Economist is committed to the assumption that humans are hyper-rational, and they maximize. ONLY theories satisfying these assumptions will be examined for validity. This means that there is NO QUESTION of looking at human behavior itself to see whether or not this hypothesis about behavior holds. Rather, the ONLY problem is to find the FUNCTION which is being maximized. Economists start by using Expected Utility theory. A rather large number of empirical examples show that this theory does not match human behavior. Nonetheless, this continues to be the dominant theory of decision making under uncertainty and continues to be taught in textbooks, even though the theory is KNOWN to be wrong.

An improvement upon this is PROSPECT theory. By making ad-hoc modifications to probabilities, utilities, and FRAMING the problem in a suitable way, this theory can achieve a MUCH BETTER match to observed behavior than Utility theory. This theory preserves MAXIMIZATION – humans maximize something. However it abandons rationality — why should humans treat probabilities INCORRECTLY. Economists cannot stomach this observed failure of rationality and so AFFIRM theories solidly in conflict with observed facts about human behavior.

NEITHER of these approaches is scientific, since both dogmatically assert allegiance to the maximization principle regardless of observation. The articles by John Hey show how one can move beyond this to a genuinely scientific methodology. He explains how many researchers have investigated search behavior, but have only been concerned with whether or not it matched ASSUMED theories of behavior. INSTEAD he proposes to investigate how humans ACTUALLY behave, without imposing any assumptions about behavior in advance. He used psychological protocols, asking subject to think out loud about the process with which they arrive at the decision on whether to accept an offer or to go on to search for the next one. As can be expected, humans cannot make complex calculations that theory requires of them, and instead they use various heuristics and rules of thumb. These heuristic work fairly well, and get them reasonable close to what someone with full information and infinite computational capabilities could achieve. Nonetheless, the use of heuristics gives radically different results about what we could expect to see in markets where these behaviors, rather than the hypothesized AS-IF behavior is used. The full lecture is linked below

For lecture slides and reference materials, links to related articles, as well as the whole sequence of lectures, see the course website: Advanced Micro II (shortlink: bit.do/ee2018)

POSTSCRIPT: The process of lecturing, trying to explain to my students how their fellow students are being duped by economic textbook, always give me greater clarity. In this lecture, I examine three approaches to understanding human behavior in the process of searching for the best wage (or searching for the best price).

1: AXIOMATIC — represented by Expected Utility. Here we know in advance what human behavior is. We do not need to look at human behavior at all. If someone ELSE studies this behavior and finds that our theories do not match actual behavior, we say that the experiment must be wrong.

2: DESCRIPTIVE — represented by Prospect Theory. Unlike economists, experimentalists and behaviorists study actual behavior. When it fails to match Expected Utility, they came up with a new theory — prospect theory — which summarizes and encapsulates a description of how humans behave in decisions under uncertainty. Economists REJECT this picture because it shows how human behavior is IRRATIONAL – and this conflicts with their FUNDAMENTAL assumptions of rationality, which must be maintained regardless of any inconvenient facts or observations or introspection.

3: SCIENTIFIC: An accurate description permits us to proceed to the next stage, which is to try to understand the REASONS for this behavior. For example, we observe that most people are risk-averse. They prefer the certain outcome of $50 to a gamble with offers $0 and $100 with equal probabilty. Now we can ask why — this is with regards to unobservable, hidden motivations, about which we can never be certain. A good explanation for this is REGRET. Because of our psychological makeup, the flatness of the utility function in gains, a win of 100 does not feel vastly superior to a win of 50. But the real kicker is the feat that if I take a gamble and lose, I will feel so stupid. Avoiding the regret that might occur when I say I should have taken that certain $50 might be the explanation for risk aversion.

Actually, even “reverse Modus Ponens” is not a good description of Friedman’s methodology — there is an added F-Twist: If we can FIND some observations C such that theory T implies them, then we affirm theory T, and IGNORE any other implications of T which actually conflict with observations.

The METHODOLOGICAL point is the Friedman, like all nominalists and instrumentalists, GIVES up on the possibility of understanding human behavior. All he wants is a model which provides a SUPERFICIAL match to some observations. However, many many real life situations show that this is NOT ENOUGH — we need to have a deeper understanding, in order to be able to explain economic and social phenomena. See also previous related post on Economists Confuse Greek Methodology with Science

“… the race is not always to the swift, nor the battle to the strong …” Ecclesiastes 9:11

In the late 19th century, a battle of methodologies (“Methodenstreit”) took place, which shaped the future of economics. The German Historical School lost out to the newly emergent, quantitative, mathematical and scientific approach. This led to a re-conceptualization of economics as a science similar to physics, which studies the economic laws of motion of societies. For a detailed account of this battle, and its effects, see “How Economics Forgot History,” by Geoffrey Hodgson.

1. Contemporary Methodology:[humans are predictable robots] The idea that economic theory is a science like physics has extremely unpleasant and counterintuitive consequences. We look for universal laws of economics, which apply equally well to Pakistan, France, Brazil, Russia and Nigeria. Furthermore, they apply equally well in the seventeenth, nineteenth, and twenty-first century. The trade theory of economists must apply equally to trade between Ghana and England, India and Pakistan, and the Huron and Iroquois tribes. Since the ability of human beings to shape their destiny in accordance with visions cannot be fit into a scientific framework, human behavior is reduced to that of a robotic pleasure machine, which follows precise mathematical laws.

2. Marxist Methodology:[social and political structures are determined by economic structures] A key element of Marxist methodology is that economic relations of production are fundamental. These determine the political and social superstructures. Marxist methodology is far richer than current methodology, which removes history, and human beings, from economics. Nonetheless, Marxist methodology gives primacy to materialistic conditions of productions, and considers society and politics as important secondary consequences.

3. (Polanyi’s Methodology):[material circumstance shape human societies, but also human vision and ideas shape material circumstances] Whereas conventional methodology restricts attention to the material circumstance, and Marx considers material circumstances as primary, Polanyi uses a bi-directional causality. Human ideas and visions can shape history, and conversely, the economic relation of production shape human ideas and visions. For more discussion of the radical implications of this entanglement of ideas and materials, see my earlier post on “Meta-Theory and Pluralism in Polanyi’s Methodology“.

These are three distinctly different methodological principles. In the rest of this lecture, we will look at nineteenth century European history through these three different colored glasses and see how they help us understand the economic, social and political changes which occurred during this period. Our goal will be to establish that “entanglement” occurs – that human ideas are both shaped by, and shape, history. In particular, economic theories are used by humans to understand historical experience, and also to guide social responses to this experience, and attempt to mold history in favorable directions. An extremely important consequence of this entanglements is that economic theories cannot be understood when detached from the historical context in which they were born. As Polanyi explains clearly, modern economic theories were produced in nineteenth century England, and to understand these theories, it is necessary to understand European history of that era.

The failure to see the impact of ideas on history was due to the overwhelming influence of a materialist view of the world, which had come into existence following the success of Newton’s laws in explaining diverse phenomena. Since material substances follow laws, they could not be affected by ideas. This duality and divide between spirit and matter has been influential in shaping Western epistemology, and in making it difficult to see the influence of spirit on matter, due to ideological preconceptions.

Before proceeding to the complexities of European history, we will do a dry-run of the conceptual framework we are using within the simpler context of hunter-gatherer as well as feudal societies. The 90m Video-Lecture linked below, discusses the co-evolution of economic theories along with the historical context in 19th century Europe:

Textbooks, like Mankiw, state that the four claims listed below are at the center of modern economics. Our goal in this paper is to show that all four of these claims are wrong.

1. Participants in market economies are motivated by self-interest. (SI) – In fact, cooperation, service, recognition and status in community, and reciprocity are very strong motivators of human behavior.

2. Decentralized market economies work very well, and maximize the welfare of society as a whole. (FM: free markets). As illustrated by the Global Financial Crisis, unregulated markets lead with regularity to disasters and crises.

3. The reason for excellent functioning of decentralized market economies is that all participants are motivated by self-interest. This self-interest works better than love and kindness in terms of promoting social welfare. (GG: greed is good). This is absolutely false, and the opposite of the truth – love and kindness work much better at promoting social welfare.

4. The principles listed above were summarized in the concept of the “Invisible Hand” by Adam Smith. (AS). Adam Smith can be blamed for many wrong ideas, but this is not one of them. In fact, free market economists attribute this theory to Adam Smith to create legitimacy for their ideas.

Detailed presentation of the paper is available in the following 1 hr. video.

Currently, I am teaching a course in Advanced Microeconomics where I have started with the premise that conventional economic theory, both Micro and Macro are fundamentally wrong. The number of ways in which they are wrong cannot even be counted. Instead of enumerating errors, the course is devoted to providing a constructive alternative. A lot of the early lectures deal with the basic concepts of optimization and equilibrium, the fundamental building blocks of conventional courses, and explain how these are wrong. I also explain how economists are using a wrong methodology, and how they misunderstand the concept of a theoretical model, and the relations between models and reality. The video-taped lectures, PPT slides, and some supporting materials, are available from my website: https://sites.google.com/site/az4math/

Originally, I had not planned to teach Karl Polanyi because his theories are significantly more complex than those of Karl Marx and Adam Smith. However, because the class has been very receptive, and has understood the what I have been teaching, I have decided to explain his ideas. We have already started discussing his ideas starting from Lecture 13, and have finished Part I of the Great Transformation in Lecture 16. In order to prepare for the complexities of Part II, I have distributed the following handout to the class, to explain the complex general methodological framework which underlies Polanyi’s analysis.

This is an outline of the lecture 3 in Advanced Microeconomics — expands somewhat on the slides available from the link. This should be useful to heterodox economists looking for ways to teach an alternative course, radically different from conventional approaches. First two lectures consisted of some preliminary math, and can be skipped without lack of continuity. Video of the lecture (90m) is available at the bottom of the post.

Supply & Demand is Central to Economics: This is the modern Theory of Value. The market price determines the value – this is in conflict with classical conceptions of value.

BUT, this theory is WRONG! The central question in theory of Value is: HOW are prices determined? Why are water and tomatoes cheap, and why are diamonds expensive?

Current answer is the Supply and Demand theory of economics. Classical economists’ answers were Labor Theory of Value.

Modern Answers are seriously deficient. Classical Schools had substantially more insight into these questions. We will be discussing classical thinking (Adam Smith, Ricardo, Marx, Sraffa) later in the course. This lecture deals with: Failure of Supply & Demand in Labor Market. This failure was the Raison-d’etre of Keynesian Economics

Recent active learning experiences have been associated with “flipped” or “inverted” classroom (Norman and Wills, 2015). Indeed, this method has been receiving increasing attention by professors that search for alternatives to traditional lectures so as to cover some topics of the course content.

By adopting the flipped classroom in economics instruction, professors out to enhance a larger pre-class involvement of the students not only by reading the selected bibliography but also by watching instructional videos.

Before the class, professors provide instructional short videos (five to fifteen minutes) that cover the main ideas related to a selected topic of the syllabus. The videos generally emphasize theoretical approaches, definitions, formulas and graphs. Recent evidence shows that many professors actually record a narration of the lecture slides and notes.

As students should watch the video before the class, professors can privilege active learning methods during class time. Therefore, the class activities aim to apply the material that was covered in the videos in order to enhance a real-world approach to economics education. These activities- that are supervised and oriented by professors – can include, for instance:

Presentation, analysis and discussion of real-world problems

Team–work exercises oriented to solve practice problems followed by class-room discussion of the main results.

Indeed, internet technologies are also affecting the economics classroom. Topics in macroeconomics, microeconomics, international economics, financial economics, among others, can certainly benefit from flipped classrooms since this teaching practice does not mean the replacement of professors with videos.

Before proceeding with Re-Reading Keynes, I would like to clarify the issue of exogeneity and endogeneity, which he understands, but most of his followers failed to understand. This is to clarify a segment of a phrase he uses in describing the four ways in which level of employment can increase within the framework of the classical theory of economics. The fourth factor listed by Keynes appears somewhat mysterious in the original text:

(d) an increase in the price of non-wage-goods compared with the price of wage-goods, associated with a shift in the expenditure of non-wage-earners from wage-goods to non-wage-goods.

== in the previous post (P9: Theory of Employment) I re-stated this as an exogenous increase in real wage, to clarify what Keynes wanted to say. However, (d) above is what Keynes actually wrote, and I want to explain why Keynes wrote in this way. This involves an excursion into the supply and demand model, and the concepts of exogeneity and endogeneity.

What Keynes is saying here is that if there is an increase in demand for luxury goods consumed by aristocrats, and an associate decrease in demand for necessities purchased by laborors, then the real wage will rise and that will increase employment. Keynes is very careful to create a scenario in which the real wage rises due to EXOGENOUS factors shift in demand by non-wage earners — the aristocrats. What Keynes understood is something basic which is not understood by modern economists like Varian when they discuss the supply and demand model — ONE CANNOT CONTEMPLATE VARIATIONS IN AN ENDOGNEOUS VARIABLE (because endogenous variables are not free to move; they can only change if some of the exogenous variables which affect them change). This means that asking what consumers will demand if the price changes is a WRONG question — prices are endogenous and they cannot change by themselves. An increase in price cause by shortfall in supply would lead different consequencs from an increase in price caused by an upward shift in the demand. If a consumer is asked what he will do when the price changes, he should ask WHY did the price change, because his response to the price change DEPENDS on cause of the price change. He cannot provide a response to the question without learning about the cause, and whether or not this is a temporary or permanent change.

Comments on Varian: Intermediate Microeconomics. Chapter 1, which sets up a simple supply and demand model.

Brief Summary of Post:

These comments are about the first few pages of the chapter. Quotes from Varian are in italics. Criticisms are made in this post about the concepts of models, optimization, equilibrium, and the concept of exogeneity, as dealt with by Varian. Models are used without explicit discussion of the relationships between model and reality, which is essential to understanding how models work. For an extended discussion see my lecture on Models Versus Reality. The post explains why optimization, taken is tautological by Varian, is false as a description of consumer behavior. For an extended discussion of the conflict between axiomatic theory of consumer behavior and actual human behavior, see my one hour video: Behavioral Economics Versus Neoclassical Economic Theory. Similarly, the decision to study only equilibrium behavior handicaps economists, making them blind to disequilibrium events like the Global Financial Crisis.